September proved to be another tough month in what has been one of the toughest periods for asset allocators in decades. Stocks and bonds have now declined in each of the first three quarters of the year.
Our core view for choppy markets, up in quality and defensive positioning over the next six to 12 months, remains intact. This global tightening cycle is set to weigh on economic growth well into 2023 given that monetary policy works with long and variable lags.
Thus, even if the Federal Reserve (Fed) pivots or inflation softens in the fourth quarter, which may energize a risk-on rally, it likely does not change the downward trajectory of the economy and challenging market backdrop over the medium term.
One only needs to look back to 2000 or 2008 to see that a shift in Fed policy alone is not always enough to stop an economy on a downward trajectory. However, after a 16% decline since the August highs, and given a very oversold market and depressed positioning, we don’t view this as a time to press a negative view in the short term.
It was the best of times; it was the worst of times
We are now seeing the flip side of the stimulus coin. Faced with a once-in-a-generation pandemic, fiscal and monetary authorities around the world brought out the bazookas and flooded the global financial system with unprecedented liquidity early in 2020. This massive stimulus alongside the suppression of interest rates not only arrested a severe economic downturn but aided the sharpest economic and market rebound in modern history.
The unintended consequences of the massive accommodation have caused central bankers to flip just as abruptly. The primary focus is now doing whatever it takes to bring down enemy number one, inflation, even at the cost of near-term economic pain. This is evident in the most aggressive global tightening cycle in decades.
Moreover, the market’s acute negative reaction to a proposed large stimulus package from the U.K. at a time of heightened inflation is reflective of a more limited toolbox for policy makers to support markets.
The shift in policy support is giving rise to a wide range of potential outcomes and fostering much higher levels of volatility. The so-called risk-free rate, the 10-year U.S. Treasury yield, is the benchmark off of which basically all other asset classes are priced. It has not only moved up dramatically but is also showing the highest volatility since the global financial crisis. This is reverberating across the capital markets.
“One of the most important implications of the sharp reset in yields is the demise of the oft-cited acronym of the past decade –There Is No Alternative (TINA). Stocks have competition again.”
One of the most important implications of the sharp reset in yields is the demise of the oft-cited acronym of the past decade –There Is No Alternative (TINA).
Stocks have competition again. The 10-year U.S. Treasury yield touched 4% for the first time since 2010 and has risen sharply from the 1.5% level at the start of the year. The 2-year U.S. Treasury yield is also above 4% ─ the highest since 2007 and up from about 0.25% a year ago.
Moreover, while equity valuations are much improved, they do not appear compelling in light of the current risks to the economy and earnings and compared to where they bottomed during the more recent market lows in 2018 and 2020.
A few silver linings in a sea of gloom
From a short-term perspective, markets are vulnerable to good news given dour sentiment and depressed investor positioning. Furthermore, news that is better or worse relative to expectations tends to mean more for markets than good or bad on absolute basis.
The percentage of bearish investors has exceeded 60% for two consecutive weeks for the first time in the history of the American Association of Individual Investors survey, dating back to 1987, and global fund managers hold record equity underweights. Stocks enter the fourth quarter in the most oversold condition, or stretched to the downside, since the mid-June lows and, at down 25%, is already pricing in the median recession.
From a longer-term perspective, the sharp valuation reset in asset classes means our capital market assumptions, covering the next five to 10 years, will be going up. And with the sharp increase in yields, the outlook for diversified portfolios is much improved. It has just been a painful way to get there.
To be clear, the road to realizing those higher returns will likely be rocky, and it’s not time to be on offense, but time frames matter as most investors have longer time horizons than just the next several months.
In this fast-moving environment, our view is that a more tactical approach will be helpful in navigating the markets. This month, we are using the sharp rise in interest rates to upgrade our fixed income view to neutral. We continue to emphasize higher quality fixed income, such as government bonds, where yields are productive again. With recession risks high, investors still are not adequately being compensated for taking on credit risk, such as in high yield corporate bonds, which we downgraded earlier this year.
On the equity side, we maintain our long-standing bias to the U.S., which we view as the big blue-chip country. Given that the U.S. is now a significant energy producer, it is also in a better place to deal with geopolitical uncertainties, and a strong U.S. dollar has tended to go hand-in-hand with its relative outperformance. While small caps are extremely cheap, we remain neutral considering the slowing economic cycle is working against them. Likewise, our sector outlook is primarily focused on defensive areas and the energy sector.
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